Rajan's Aggressive Policy Augurs Well for Growth

Published: 30th September 2015 06:00 AM  |   Last Updated: 29th September 2015 11:10 PM   |  A+A-

The RBI has been aggressive in its monetary policy stance this time and has gone in for 50 bps cut in interest rate. Given that the fundamentals of the economy and risk factors have not changed significantly since the last policy announcement, the RBI has taken a pro-growth step. It is confident that inflation will be below 6 per cent by the year-end and has lowered its forecast for GDP growth rate to 7.4 per cent.

The RBI has taken a definite move from the monetary policy standpoint with this rate cut. The question is how effective will this be in reigniting growth. Two issues need to be addressed. The first is the transmission mechanism which the RBI has stated will be discussed with the government. This means, the government may be expected to talk to public sector banks (PSBs) and urge them to lower rates. While in the last few months private banks have lowered rates, mainly due to greater exposure to the retail segment, PSBs have been relatively slow. But it may be expected that once they do, the private banks will follow suit. Further, the Finance Minister has spoken of the need to address the issue of interest rates on small savings which are presently high. Assuming both are done, there would be a tendency for rates to come down.

However, anecdotally speaking, when rates are lowered, around 75-80 per cent of the same is passed on through deposit rates and around 50 per cent for lending rates. The time frame could be between 6-9 months. While this will happen, the only concern could be that financial savings may be affected at a time when they are already declining. This may not be good news for households, which have been affected negatively with high cumulative inflation over the last three years and witnessed low growth in real income. With interest rates declining, bank deposits will definitely become less attractive and if the government lowers rates on small savings, which includes post-office accounts and provident funds, the impact will be severe, especially so, as these avenues are used more by people with relatively lower income levels. A fallout could again be a diversion of household savings to gold, which was the case earlier in FY13 and FY14.

The second is growth per se. Will growth revive in a significant manner? The answer is that we may have to wait longer for this to happen. Today, growth and investments have been affected by various factors, more on demand side and due to other institutional considerations like land, power, infrastructure etc. Interest rate is an important, though, not decisive factor in influencing investment decisions. This is why even when rates were lowered in FY13, investment did not pick up. Manufacturing is operating at 70 per cent capacity utilisation and would not invest unless demand picks up. The private sector infrastructure is waiting for the government to kickstart the process. Hence, RBI’s move should be seen more as creating the right interest rate environment when demand picks up. We may not expect any immediate revival in growth. This is probably also implied in the RBI lowering  its GDP growth rate forecast for the year to 7.4 per cent from 7.6.

Such rate cuts would, however, be beneficial at the retail-end, where banks have been working on increasing their exposure. As these loans have a lower propensity to turn into Non-performing assets (NPAs), the RBI rate cut could probably first be seen in lower rates on the retail portfolio. This would be good for persons buying houses or consumer goods. In fact, the RBI has also proposed to lower the risk weight attached to affordable housing which in turn will help them reduce rates on such loans.

From the banking perspective, they should be prepared to lower rates on both the sides. In the past, they had lowered deposit rates at a faster pace than lending rates. But this time, given the focus of both the RBI and the government, there would be pressure on lending rates. As most deposits are contracted at higher rates and cannot be touched, the loan portfolio can get repriced if companies borrow at a lower rate to repay old loans. Therefore, this rate cut may turn out to be an unmixed blessing for them.

In a rather interesting move, the RBI has also enhanced the FPI level in GSecs to 5 per cent of outstanding compared to a ceiling of $30 bn presently. Also, they have been allowed to invest in SDLs which will be a good gap for the states. On the whole, this progressive structure will ensure that FPI will automatically get more room as the government borrows more every year. This will help our balance of payments and in a way, help stabilise the currency. However, the immediate impact will be muted as the Ernest rate differential between Indian and foreign rates is likely to narrow down with the RBI lowering rates and Fed likely to increase them in December.

Can we expect more such rate cuts? While it is hard to conjecture how the RBI will interpret the economic situation as well as future outlook every two months, assuming that inflation remains low within the range of 6 per cent, another 25-50 bps cut may not be ruled out unless something really negative happens, especially in the world economy, which is presently not foreseeable. While interest rate is just one part of the growth puzzle, the RBI appears to have done its bit to support growth. But as mentioned earlier, several other pieces have to fit in to make growth happen. But the household saver would definitely be less than satisfied if all the savings rates come down, which will impact financial savings. This will be a factor that has to be reckoned for possible higher growth.

 (The views expressed are personal)


The author is chief economist at Care Ratings.


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